Many companies in the S&P 500 continue to boost their dividends at a steady clip as payouts rose roughly 7.8 percent through this year's first quarter. Surging cash balances and rising after-tax cash flow suggest even higher dividends to come.
Trouble is, dividend increases haven’t been keeping up with stock price gains. As a result, that average dividend payer in the S&P 500 sports a 1.85 percent yield, according to multpl.com. 10-Year Treasuries, with yields around a percentage point higher, also aren’t capable of producing robust income streams.
That’s why preferred securities remain in favor. Danny Prince, head of iShares product consulting, notes that in the 11 years that the iShares U.S. Preferred Stock ETF (PFF) has been trading, its yield has never fallen below 5.0 percent. (The current trailing twelve-month yield on that fund is 5.61 percent). “They’re a really attractive source of income, relative to Treasuries,” says Prince.
Preferreds can also provide strong portfolio diversification. That’s a key consideration for anyone concerned that stock and bond prices may be headed for a pullback. “Preferreds tend to avoid the sharp price swings you’ll find with common stocks, making them great diversifiers,” says Jay Hatfield, chief investment officer at Infrastructure Capital Advisors LLC, who co-manages two InfraCap ETFs focused on preferred securities. “With a beta of around 0.2, they are really more like bonds than stocks.”
That’s not to say preferred securities are risk-free. “They can have sensitivity to interest rates, though depending on the direction of credit spreads they may not necessarily fall in price when Treasury prices are falling” says Prince.
The PFF fund from iShares has modestly fallen in value over the past five years, pushing its total return down to 4.54 percent annually in that time. And it fell 23 percent during the market downturn of 2008. That’s painful, but it’s still better than the 40 percent drop for the average global stock fund, according to Morningstar.
And PFF has a standard deviation of 4.2 over the past five years, compared to 9.0 for the S&P 500, according to iShares. Also, it’s important to note that few firms actually halted dividend payments on preferreds during last decade's market crash.
With $16.3 billion in assets and a 0.46 percent expense ratio, PFF is the category’s largest fund. It tracks an underlying index with a heavy concentration in financial services, which account for seven of the top 10 holdings. Banks tend to be frequent issuers of preferred stocks, says Prince.
Investors who already have enough exposure to financial stocks may prefer (no pun intended) to have more diverse sector exposure with the VanEck Vectors Preferred Securities ex Financials ETF (PFXF).
The fund, which has a 0.41 expense ratio and around $510 million in assets, carries a juicy 6.4 percent 30-day SEC yield. Electric utilities, telecoms and real estate investment trusts account for roughly two-thirds of the portfolio.
InfraCap’s Hatfield thinks REIT preferreds are an especially appealing category. “They are backed up by hard assets and they performed very well in the last three recessions,” he says. He’s been managing the InfraCap REIT Preferred ETF (PFFR) since its launch in February 2017. The fund has $22 million in assets and aims to tackle one of the biggest challenges with preferred stocks.
“Preferreds have seen such strong demand that many of them now trade above their call price,” says Hatfield. That creates a negative “yield-to-call” scenario where the preferreds could be redeemed at a price lower than the current trading price.
InfraCap buys preferreds that have a yield-to-call price that is at least three percent above the price at which shares are bought, ensuring that portfolio holdings won’t be sold at a loss.